Sterling sinks as dollar shrugs off Federal Government shutdown

Investors continued to focus on the political stand off over the budget in the US and the more important one coming soon about the expansion of the Treasury’s debt ceiling. Financial markets appear to share our relatively calm view of the likely resolution of the conflict. The dollar traded in tight ranges against the euro and US equities actually rose slightly for the week in contrast to the moderate falls seen in most other stock markets. With most US macroeconomic data on hold due to the Federal shutdown, we think that the impasse in Washington will continue to drive markets. Our view is that the conflict is likely to be resolved before any lasting damage to the economy occurs, and certainly before payments on US debt obligations are affected. However, we continue to monitor events very closely.

GBP

Sterling became a victim of the very high expectations that had developed around the UK economy. The latest key figures showed some moderation, but the slight downticks in the PMI business surveys from quite high readings do not significantly change the picture of a decent recovery driven by buoyant domestic demand. The currency had a rough time of it, dropping around 1% against both the Euro and the US dollar. We think that a resolution of the budget stand off in the US will bring about a sharp drop in GBP/USD but a sizeable rally in the GBP/EUR rate, since sterling has been outperforming lately whenever risk aversion eases up. We do not expect next week meeting of the Bank of England to bring any news and therefore GBP will mostly be driven by external events and news until the publication of the 3Q GDP report in two weeks time.

EUR

Last week was fairly positive in terms of news out of the eurozone. The Italian Government successfully repulsed Silvio Berlusconi’s attempt to force early elections. Employment news throughout the eurozone indicated flattish job creation, in a hopeful sign that the labour market is at least stabilizing at its currently low levels. However, the euro failed to rally against the dollar on these news, in spite of the political turmoil across the Atlantic. Part of this weakness could be attributed to the downward surprise in inflation, which printed at 1.1%, down 0.2% from the previous month, and continues to trend lower from the ECB’s target. However, we think that stretched long positioning in the common currency is playing a bigger role and the euro remains vulnerable to a resolution of the budget impasse in Washington.

USD

The release of the all-important payroll report was delayed sine die due to the Federal shutdown in the US, as will most key macroeconomic releases. Therefore, all eyes remain firmly fixed on the farcical conflict between a faction of the Republican party in the House of Representatives and pretty much the rest of the political establishment. The macroeconomic impact so far is limited, and past instances of Federal shutdown suggest that the damage to confidence resulting from the shutdown will be contained. Much more important is the upcoming battle over the lifting of the Treasury borrowing limit. Without an agreement in place, the Treasury will have to start deciding which payments to make around October 17th. We believe that fears of an outright default are overblown. Even in the case that no agreement is reached and the White House does not decide to ignore the limit, it is exceedingly unlikely that the Treasury will fail to make any payments due on the debt; other obligations are likely to be delayed instead. We think markets are right to remain in agreement calm over the situation, but we will continue to monitor developments very closely.